Should Debt Payments Be Deductible?

The American government loves debt.  It offers special tax breaks to interest payments-mortgage interest, if you're a person; all interest, if you're a firm.   This has a number of pernicious effects.  On the personal level, it's a gift to home sellers--as we've seen with the homeowner's tax credit, any special break you give to home buyers tends to end up in the pockets of home sellers, as the buyers bid up the price to their maximum affordable net monthly cost.  On the corporate side, it privileges debt over equity financing.  In both cases, it adds considerable risk, since the fixed debt payment schedule may not match up with the flow of income.

Virtually all economists, aside from David Lereah and his successors, think that the mortgage interest tax deduction should be eliminated, using some sort of sunset combined with a grandfather clause so that we don't suddenly push millions of more American homeowners into foreclosure.  Equalizing the treatment of dividends and interest payments is also popular.  But I don't usually hear people advocating, as Felix Salmon does, eliminating the deduction for corporate interest payments.  In a post titled "What are the arguments for privileging debt?" he says:

The weird thing for me is that when I start banging this particular drum, I always get exactly the same answer: "yes, great idea, not gonna happen". But is there any intellectual justification whatsoever for making corporate interest payments tax-deductible? I can see an argument for a carve-out for highly-regulated banks, since their entire business is based on making profits from the spread between the rate at which they lend and the rate at which they borrow. But banks aside, why should companies pay lots of tax on dividends, and no tax at all on bond coupons?

In a way it's depressing: if this were a real debate and Paul Volcker had a remote chance of making interest taxation happen, then surely there would be no shortage of academics and corporate lobbyists making the case for keeping the status quo. The fact that they're not even bothering is all the evidence we need that this isn't even going to reach trial-balloon status, let alone get signed into law.

But still, the question remains: if they were to start taking this seriously, what arguments would they use? After all, as Surowiecki notes, the likes of Brazil and Belgium seem to do perfectly well without giving debt this artificial advantage

Maybe I was brainwashed by the infamous Chicago School, but I can think of a lot of reasons for the tax treatment of debt.  After all, let's think about why corporate debt is deductible, while personal interest largely isn't.  Personal income is defined for tax purposes, broadly, as what you were paid this year.  But corporate income is defined as what you were paid (revenue) minus what you had to pay others.

That's because government generally assumes that the operating expense and capital requirements for an individual are roughly the same from person to person--you may think you need a 5,000 square foot McMansion and a power boat, but Uncle Sam disagrees.  On the other hand, companies  differ greatly.  Firms like Apple or Kelly Services really do have very different operating and capital structures from Alcoa or Caterpillar for good reason.  Heavy industrial companies need more capital to make new investments, and it can make good sense to match the duration of the financing to the expected life of the asset.  That's accomplished by borrowing money, not floating a new stock issue or trying to accumulate enough retained earnings to keep up with your competitors.  On the other hand, service and software companies basically need some computers and an office lease--their assets are mostly brands, patents or copyrights, and what economists call "firm-specific human capital", which is to say, processes and know-how. 

There are two core problems with simply eliminating the tax deduction on interest.  The first is conceptual:  the corporate income tax is supposed to tax, well, corporate income, which is to say, profits.   I doubt Felix would advocate treating debt payments on the financial statements as something other than an expense--replacing net income with EBIT, say. Money that has gone to lenders or the taxman is actually gone; shareholders don't get it.  It would be grossly misleading to tell shareholders, "We made $100 million this year" if you've left out the $120 million in debt and tax payments you had to make.

The second is that this would make companies that do use debt finance much more risky.  Companies with big capital requirements could find that in a downturn, they suddenly had large debt payments, negative cash flow, and a sizeable tax bill.  As a first principle, the tax code should aim to avoid unnecessarily pushing vulnerable firms into bankruptcy.

There's actually a third problem:  it's possible to create debt-like instruments that are deductible--complicated lease arrangements, for example.  We really don't need any more rules for companies to game.

This seems to me like a better argument for making dividends deductible, or capping the amount of debt that's deductible.  But to drag out my regular hobby-horse, it's an even better reason for getting rid of the corporate income tax entirely, along with the special tax rates for capital gains and dividends.  Tax income once, when it's distributed to the owners, and then tax that income just like any other kind of income, regardless of source, so that Paris Hilton pays a higher rate on her corporate-derived income than your middle-class grandmother.  Then let companies decide which mode of financing makes the most sense for their capital structure, rather than their tax bill. 

It's true that this would discourage dodgy LBOs and other temptations to inappropriately load up your company on debt.  The problem is, it would also discourage appropriate debt.  I think there are better ways to skin this cat.